Outlook 2021: Debt & Gold

Forecasting is a tricky business and 2020 showed how Black Swans flying at you out of nowhere can make you look foolish. But looking back at the debt outlook and strategy we recommended a year ago, we kept you from some money-making opportunities, but we’re also glad we erred on the side of caution.

In January 2020, we took the view that it wasn’t a great time to buy long-term g-secs, gilt funds or corporate bond funds with longer maturities given limited downside to interest rates. At the time, RBI’s repo rate was at 5.15%, near its two decade low of 4.75%. We were quite wrong on this score.

As Covid-19 fanned recession fears, the MPC decided that extra-ordinary times called for extra-ordinarily low rates and slashed the repo rate to 4 % in May 2020. RBI actively bought longer g-secs to keep government borrowing costs low. This helped investments in longer maturity debt (duration calls) pay off. Both gilt funds and medium to long duration debt funds delivered double-digit returns in 2020, defying our expectations.

(Part 2 of our outlook, on equity markets, will be published on Friday. Do look out for it!)

Keep the duration short

Having missed the opportunity in duration so far though, this is not a good time to hop on to the bandwagon. After slashing rates to 4% way back in May, the MPC has been sitting on the fence since. Hopes for further cuts have been slowly fading as sticky CPI inflation hovering at 6-7% since April and signs of returning inflation globally have led to questions being raised about whether easy money policies should continue. The government, however, is toying with the idea of upping its CPI inflation target of 4 % to keep the monetary stimulus party going.

Given this tug-of-war, it looks likely that the MPC will remain on pause for the first half of 2021. Persisting inflation or a continuing economic recovery however could force a normalisation of repo rates to 5-6% in the second half of 2021 or later. Should this happen, longer maturity gilt or corporate bond funds will give up some of their recent gains.  Even if repo rates stay unchanged for the whole year, there’s clamour for RBI to begin closing the taps on excess liquidity it has been pushing into the banking system, to rein in inflation. This liquidity has been the key to the 10-year gilt falling below 6%. Should it normalise, the g-sec yield may move up.

Overall, 2021 may be a year of two-way moves for gilt and long duration funds, making this a dicey time to invest in them.This makes ultra-short and short duration debt funds the better parking ground for your money right now.

Yes, with short term borrowing costs for the government and top- notch companies at rock-bottom levels (see table above) your return expectation from such funds needs to be low, in the 4-5% range. But you can hope for an improvement once market rates get back to pre-Covid levels, in about a year’s time. Floating rate debt funds make for a good option to play this trend too. If you’re an FD investor – invest for the lowest possible tenure of 6 months to 1 year.  Please refer to our shortlist of very short duration funds and deposits to make your choices.

AA may pay

If the opportunity in g-secs is limited, should you attempt to make extra returns by investing in corporate bonds? Well, with the entire market preferring safety, the extra rates (spreads) that AAA rated companies pay over the government is very minimal today (about 40 basis points for 5 years). Plus 5-year plus corporate bonds also carry the risk of losing money if rates firm up.

For better yields therefore, investors may need to consider AA+ or AA rated entities in the year ahead. Here, the choices you make need to be somewhat selective as some companies may see their finances recover quickly from Covid while others may suffer reverses. Overall, with many members of India Inc deleveraging during Covid, investing in AA rated corporate bonds seems safer than investing in AA rated NBFC bonds. The financials of NBFCs don’t yet reflect the damage wrought by Covid given the Supreme Court standstill on recognition of NPAs since August. Here again, ultra short or short duration debt funds may best fit the bill.

In our Prime Funds, HDFC Floating Rate Debt is an option, with about 11.9% of its November portfolio in papers below AA+. But picking funds with lower-rated exposure can be tricky, as it needs looking at the nature of the portfolio, extent of exposure, and so on. When the tims is ripe, we will separately cover such funds very selectively. Though such funds may be outside our Prime Funds list, that may be good add-ons on the AA-front.

Small savings score

One piece of advice we gave in January 2020 that worked very well was that investors make the most of high interest rates on post office schemes. In January, we suggested that with a 6.9% interest, post office time deposits beat corporate and NBFC options hands down on risk-reward. We also suggested that senior citizens make the most of the high returns, by locking into 8.6% on the Senior Citizens Savings Scheme for 5 years and 8% on the Pradhan Mantri Vaya Vandana Yojana for 10 years.

For younger folk, we suggested RBI’s 7.75% taxable bonds despite the 7-year lock-in. In hindsight, this has worked quite well. Rates on the SCSS and Vaya Vandana Yojana have since moderated to 7.4% and GOI’s 7.75% taxable savings bonds have been discontinued, with a floating rate bond offering 7.15% taking its place instead.

Today, sharp cuts in interest rates on the longer term post office schemes such as 5-year time deposits (6.7% for 5 years), Monthly Income Account (6.6%) and 5-year NSC (6.8%) have made them less attractive. Given that the government has been sourcing a larger portion of its borrowings from small savings and has been reluctant to cut these rates, however, the rates on these instruments may trend up when market rates pick up.

It’s a good idea to park money in 1-year time deposits in anticipation of shifting to better rates a year from now, while avoiding POMIS, NSC and 5-year deposits. The SCSS (7.4%) and Vaya Vandana Yojana (7.4%) still offer good returns and can be considered by regular income seekers. For non-seniors, the GOI 7.15% Floating Rate bond is a good option.       

Gold

With stock market valuations at all-time highs (Nifty 50 PE of >35) and the bond rally showing signs of running out of steam, the need to own some gold in your portfolio as an insurance against market reversals is higher than ever today. We suggest allocating upto 10% of your portfolio to gold, especially if you own equities through gold ETFs or sovereign gold bond exposures. We had recently, in early December, made the case for allocating to gold, which explains our reasoning in detail. Read it here – https://www.primeinvestor.in/is-it-time-to-buy-gold/.

Read our equity outlook here.